As commercial banks begin to suffer the same risk problems as investment banks, risk management is becoming more important in the sector. Heather McKenzie reports on the biggest issues and the tools that can be used to manage them.
Risk management has not always been an equal player at the table in commercial banking, but Basel II and, more recently, the subprime mortgage crisis in the US have pushed risk management up the agenda.
Although the subprime mortgage problems are not directly related to the business of commercial lending, there are lessons to be learned. Robert McDowall, senior analyst, Europe, at financial services consultancy TowerGroup, says that commercial banks should be aware of the issues that the subprime crisis raised and learn from them – particularly as investment banking products are being packaged and distributed on a wider basis to commercial banks.
Asset valuation
“Most commercial banking involves secured lending against something that is tangible, like property or assets. It is up to the bank to ensure it knows where the assets are and to value them periodically. However, more and more, banks are lending to organisations that do not have tangible assets and when you lend against intangibles (such as intellectual property or patents), it is more difficult to value those assets continually and accurately,” says Mr McDowall.
Although there are formulae for valuing intangible assets, they are models, and as Mr McDowall points out, the subprime mortgage crisis was caused in large part by banks marking to their models, rather than to the market. “The issues that affected the investment banking world are now permeating the commercial banking market,” he says.
Credit risk – the risk that a counterparty may not be able to meet its obligations – is the main risk in the commercial banking world. Mr McDowall says that, in general, commercial banks have undertaken their own credit assessments and then supplemented them with reports from rating agencies.
“There is no substitute for a bank doing its own credit assessment and evaluation, and given what has happened in the investment banking world with securitisation, the investment banks that are currently blaming the ratings agencies for their problems should have been doing their own assessment work.”
Basel II worry
However, Mr McDowall says there is a problem in Basel II, in that it advises financial institutions to be directed by the valuations of credit rating agencies. “This is an interesting dynamic. The events of the past couple of months would suggest that the credit risk pillar of Basel II will be undermined by the lack of confidence in the ratings agencies. Will the apparent reduced confidence in ratings agencies spill over into the commercial lending sector?”
In the immediate aftermath of the subprime crisis, credit ratings agencies were called to account. In Europe, the Committee of European Securities Regulators called a meeting with credit ratings agencies to discuss their role in the subprime mortgage crisis. It also conducted a public consultation, which ended on September 10, on how structured finance instruments are rated by the agencies.
Subprime hindsight
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Christian Nelissen, a partner at PA Consulting, says that with hindsight it is easy to see a number of steps that risk managers should have taken during the subprime mortgage crisis. “There were severe credit risks, and you would think that some institutions would have priced these into their models,” he says. |
“The lesson here is probably that despite the fact that risk management is becoming more important and more sophisticated, it is still ignored from time to time.”
One of the problems, according to Mr Nelissen, is that risk managers are often considered “Cassandras” (in Greek mythology, the prophet whom no-one believed) and others in a bank think that their job is to put things on hold.
However, he thinks that attitudes are changing. “Ten years ago, risk managers were like policemen – they would stop certain things happening and they would also do reporting. Now there is more coaching done by risk managers: helping people in the business to understand the risks they face and how to deal with them in an appropriate way.”
Risk survey
In a survey it conducted in 2004, on risk-based management in the banking sector, which Mr Nelissen says is still relevant, PA Consulting found that although most banks had put in place risk governance structures, many still needed to ensure that their risk strategies were well articulated and aligned with the needs of the business. “Before they close other gaps in their risk management toolsets and practices, many banks would be wise to clarify their risk strategies and ensure that they are aligned with resource plans for Basel compliance,” he says. Only 43% of the banks surveyed had quantified their risk appetites. Most banks’ boards have an active involvement in setting the risk strategy, but with varying degrees of involvement in its execution, he says.
Hypercompetitive lenders
Jorgen Roed, head of UK sales and marketing at EDB, a Nordic IT supplier, says that as profit margins decrease, commercial lenders are under more pressure to take greater risks to protect or increase revenues. “At the same time, loyalty among customers is decreasing, which puts further emphasis on new customer acquisition. This, in turn, forces greater risk as lenders become hypercompetitive,” he says. “Basel II will offer commercial lenders a number of opportunities to remain competitive.
“Many lenders will adopt risk-adjusted pricing, which will allow them to achieve IRB advanced status and, as such, allow them to set aside lower levels of capital. To achieve this, commercial lenders will require greater levels of transparency, control and accountability, and the ability to capture more extensive and efficient risk rating models,” he says.
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Craig van Ness, a partner at PA Consulting, says that sophisticated financial institutions have been spending a great deal of time and money on retooling their back office and credit risk processes to develop IRB capabilities. Those institutions are now seeking to leverage their investments by extending the approach into the front office and loan origination. |
“We have seen large groups of commercial banks pulling together their historical loan loss and recovery information, and derive from that some benchmark statistics to create models that enable them not just to benchmark and calibrate IRB under Basel, but also to use those tools to push them into the origination workflow so the lending officers have at their disposal a different way of looking at potential credit,” says Mr van Ness. “It’s a more qualitative look at the risk profile with much greater granularity.”
Such tools include workflow management, document management and decision support applications.
Tool use and performance
The PA Consulting survey found that if banks want to increase their shareholder returns significantly, they should focus their efforts on expanding their use of basic risk management tools before developing more sophisticated ones. It found that banks with less sophisticated models that were used extensively outperformed those that had sophisticated models but failed to use them properly.
“This is a trap that people are still falling into,” says Mr Nelissen. “It is great to have all the bells and whistles but unless you are making decisions that are based on the tools, they are irrelevant.” Mr van Ness says that in creating tools that are so complex, a bank may well be undervaluing the experience and expertise of the lending officers.
Technology versus policy
Mr McDowall questions how big technology’s role is in commercial banking credit risk management. “Technology can provide information but this is an area of business that is more concerned with policy issues. However, the more investment banking products are being packaged and sold to commercial banks, the more need there will be to integrate risk management systems to manage and monitor the risk of these products as well as to assess their value,” he says.
PA Consulting’s clients are focused on three areas when it comes to risk management, says Mr Nelissen. First, they want a more quantified approach, eager to “crunch the numbers” in their portfolios to work out trends and are trying to apply some of the same principles to portfolio management as they do to high-end loans, he says. The work they have undertaken on Basel II enables banks to determine how much capital they have, which they can then take to the front line and process risks more finely.
“Ultimately, this means the relationship managers get better at taking risks because they are using all the good stuff that has been done at the back end,” he says.
He adds that Basel has led to a greater focus on portfolios, and some commercial banks are moving into active portfolio management rather than reactive management. This means that rather than looking at a portfolio “every few weeks”, they can more readily work out where they can get a better price and reject risks.
“The trend we have seen since the introduction of Basel II is that banks are adopting or are trying to get more quantitative approaches to credit risk,” says Mr van Ness. “This requires the compilation of a large database of empirical information after the fact, from which they will derive a basis to determine the risks of particular types of loan assets with particular types of counterparties.
“The main objective is to achieve transparency and certainty about risk pricing. By pushing these tools into the front office, banks also get lower uncertainty about the quality of assets in their portfolio and therefore the riskiness of the portfolio.”
Operational risk
Opinion is divided about the importance of operational risk – the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events – in commercial banking. EDB’s Mr Roed says that operational risk is a consideration, particularly as commercial lending operations grow, resulting in higher volumes of transactions.
“To meet their requirements, lenders need systems that are able to handle the associated administration and to capture the process structure that has to be followed through the full loan lifecycle. This will make the bank less dependent on people, reducing the risk of human fallibility as well as increasing transparency and auditability,” he says.
However, Mr McDowall says that although there is operational risk in commercial banking, the low level of transactions means that the operational impact is relatively small compared with that in the investment banking world.
The PA Consulting survey found that banks’ attitudes to operational risk were much more conservative than those to credit or market risk. The report said: “The main area in which banks may need to develop their risk tools is in operational risk. However, there are some aspects of credit and market risk for which many banks should also consider developing tools:
- Most banks have at least the basic credit risk tools but many lack tools for analysing credit risk at the portfolio level.
- Although most banks have well-developed sets of market risk tools, there is still some scope for the development of sensitivity measures and earnings-at-risk tools.
- Banks have achieved much less sophistication in their operational risk toolsets, although a large proportion have plans to develop in this area.”
The report added that banks could increase their use of tools for all three risk types – credit, market and operational – to support business decisions. “Although many banks have a good range of risk tools, many would benefit from using these tools more widely in decision making for all risk types,” it said.
Risk limit
Most banks used their credit and market risk tools in setting and monitoring risk limits, far fewer used their operational risk tools for this purpose, said the report.
Moreover, many banks used their credit risk tools for pricing transactions, though fewer used them for structuring transactions and fewer still used their operational risk tools for these purposes, it said. Only a small proportion of banks used their risk tools – of any risk type – to allocate economic capital, said the report.
PA Consulting also found that many banks’ risk data, systems and reporting lacked the structure and functionality to enable fully informed decision making. Mr Roed agrees with this point. “If commercial lenders are to be successful in taking greater risks, far greater levels of data accuracy, process transparency and risk modelling are required,” he says.
“To date, the small and medium-sized commercial lending operations have been deficient with regards to risk modelling. This needs to be urgently rectified to embrace risk-adjusted pricing, which will allow them to forecast risk and respond accordingly. Moving to risk-adjusted pricing will allow smaller and medium-sized commercial banking operations to compete more effectively,” he adds.
